Why mortgage REITs report substantial declines in book value

The Refinance Index fell to 4.4% (to 2,245 from 2,145) in the context of a calm week in the bond market. The bond market has been re-adjusting to the idea that we may see the end of quantitative easing in fall. That said, it seems to have stabilized at these levels—at least for the moment.

The MBA reported that the share of refinance applications remained steady at 63%. Most originators are anticipating a more purchase-driven market going forward and believe we’ve seen the lows in interest rates. If we have in fact seen the lows in interest rates, home price appreciation will drive refinance activity more as previously underwater homeowners eventually get back to positive equity and take advantage of lower rates. Slowing refinance activity could be a negative for originators like PennyMac (PMT) and Redwood Trust (RWT).

Policy could have an impact, though. President Obama gave a speech regarding housing in which he said he wants everyone to be able to refinance. That means HARP 3.0 (another wave of the Home Affordable Refinance Program), which would presumably extend to non-government mortgages and would have a later cutoff date than early 2009. If this happens, expect another refinance wave.

Implications for mortgage REITs

Refinancing activity affects prepayment speeds, which are a critical driver of mortgage REIT returns. Prepayment speeds occur because homeowners are allowed to pay off their mortgage early, without penalty, and when interest rates fall, those who can refinance at a lower rate do. This is good for homeowners. However, it isn’t necessarily good for mortgage lenders—especially REITs. When homeowners prepay, the investor loses a high-yielding asset and is forced to re-invest the proceeds in a lower-rate investment. This means lower returns going forward. A rise in prepayment speeds could negatively affect REITs, like American Agency Capital Corp. (AGNC), Annaly Capital Management, Inc. (NLY), Hatteras Financial Corp. (HTS), CYS Investments, Inc. (CYS), and Capstead Mortgage Corporation (CMO). That said, the increase in rates has basically put prepayment worries on the back burner for the REITs.

However, as rates increase, prepayments become less of a problem for REITs. But increasing rates bring their own set of problems, and REITs face mark-to-market hits on their portfolio and must adjust their hedges to a more volatile interest rate environment. Mortgage-backed securities outperform in stable interest rate environments, but they’re highly vulnerable to interest rate shocks. As we’ve seen from the mortgage REIT earnings so far, virtually everyone is reporting a substantial decline in book value as higher rates have taken their toll. It would be ironic to see the only silver lining of increased rates (lower prepayment speeds) taken away from the REITs as well.